Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Thursday, March 31, 2011

SIGTARP Tells Congress that Dodd-Frank Did Not End Market Perception that Systemically Risky Financial Institutions Are Too Big to Fail

Despite Dodd-Frank’s enactment of a liquidation authority for failing systemically risky financial institutions, TARP Special Inspector General Neil Barofsky said that there is still a public perception, reinforced by global credit rating agencies, that these institutions are still too big to fail. Dodd-Frank was intended to end too big to fail, acknowledged Mr. Barofsky, and the Title II liquidation authority does wind down a failed financial institution, but there is still a market perception that these large firms will simply not be permitted to fail. As long as the executives, rating agencies, creditors and counterparties believe that there will be a bailout, he noted, too big to fail will persist.

In testimony before the House TARP oversught subcommittee, he said that the largest financial institutions continue to enjoy cheaper credit based on the existence of the implicit government guarantee against failure. Two globally influential rating agencies recently reinforced this advantage. For example, Moody’s said that the resolution regime would not wok as planned, posing a risk of contagion and most likely forcing the government to provide support to avert a systemic crisis. The rating agencies are telling the market that they do not believe that the Dodd-Frank Act ended too big to fail, said SIGTARP, and the markets seem to be listening given the discounts that large firms continue to receive.

Until financial institutions viewed by the market as too big to fail are either broken up or some structure is put in place to assure the market that they will be left to suffer the full consequences of what SIGTARP called ``their wanton risk taking’’, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous consequences.

But SIGTARP held out the hope that regulatory action is still possible to avert this scenario. He pointed to FDIC Chair Shelia Bair’s position that regulators must take a more proactive role and use the Dodd-Frank living will provisions as a tool to force systemically important financial institutions to simplify their operations and shrink their size, if necessary to ensure that orderly liquidation is possible.

Under Dodd-Frank, the FDIC and the Federal Reserve wield considerable authority to shape the content of the liquidation plans. If the plans are not found to be credible, the FDIC and the Fed can even compel the divestiture of activities that would unduly interfere with the orderly liquidation of these companies. The success or failure of the new regulatory regime will hinge in large part on how credible these resolution plans are as guides to resolving these companies.

Chairman Bair has pledged that the FDIC will require these institutions to make substantial changes to their structure and activities if necessary to ensure orderly resolution. If regulators do not ensure that these institutions can be unwound in an orderly fashion during a crisis, she emphasized, they will have fallen short of the Dodd-Frank goal of ending too big to fail. Mr. Barofsky said that if the FDIC prevails in ensuring that Dodd-Frank is used to simplify and shrink large institutions as necessary then perhaps in the long run Dodd-Frank will have a chance to end too big to fail.

In his testimony, Mr. Barofsky also favorably noted that Senators Sherrod Brown (D-OH) and Ted Kaufman (D-DE) had offered an amendment to Dodd-Frank that would changed the size, leveraging, and capital requirement standards of large financial institutions in order to prevent them from becoming too big to fail. The amendment, which was essentially the SAFE Banking Act (S3241) the Senators had introduced earlier in the year, would have limited the size of these firms by imposing a strict 10 percent cap on any bank-holding-company's share of the United States' total insured deposits and limiting the size of non-deposit liabilities at financial institutions to 2 percent of GDP for banks, and 3 percent of GDP for non-bank institutions. It would also have set into law a 6 percent leverage limit for bank holding companies and selected nonbank financial institutions.

The Brown-Kaufman Amendment was defeated 61-33, but Banking Committee Ranking Member Richard Shelby (R-AL) and Majority Leader Harry Reid (D-NV) voted for the amendment. While the amendment failed to become part of Dodd-Frank, Mr. Barofsky seemed to be suggesting that this could be a legislative avenue to take the ``big’’ out of too big to fail,